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A Simple Options Trading Strategy That Beats the S&P 500

NEW YORK (TheStreet) -- It can be a winning strategy to sell uncovered or unhedged at-the-money short-term puts, then wait until maturity and repeat the trade. Investors comfortable with the risk of equities can beat the index in the long run by exploiting a flaw in the classical option theory. Note that with the levered strategy below you can theoretically lose more than the capital invested -- think about it carefully.

The strategy is to sell unhedged at-the-money short-term puts on the S&P 500(^GSPC), wait until maturity, and repeat.

So why tell you this? I can hardly think of anything simpler. That's why I don't feel I'm revealing any substantial trade secret.

This strategy is different from the core strategy of the start-up hedge fund I'm running, and the current market regime might not be ideal to begin implementing this strategy. Or perhaps I'm just telling you this because I don't want too many people to bash front-end option premiums.

What makes this strategy interesting in my opinion is that:

It outperforms the S&P 500 in the long run, in terms of return and risk.

It exploits a flaw in classical option pricing theory.

Figures 1 and 2 compare the strategy's evolution since March 1994 vs. the S&P 500, rebased at 100 using monthly and weekly maturities. To make our results easy to reproduce, we ignored interest rates and dividends. Over the 20-year period, the S&P 500 registered a 0.41 Sharpe ratio. The monthly strategy is slightly better at 0.55, but the weekly strategy is much better at 0.76.

Figure 1. Monthly strategy (blue line) vs. S&P 500(red)

Figure 2. Weekly strategy vs. S&P 500

Data sources: Large investment bank, Bloomberg. For the period 1994-2004, the one-week at-the-money implied volatility was estimated through a linear regression against one-month implied and 10-day historical volatilities.

You start with $100 of capital, sell naked at-the-money puts with $100 notional, and roll on every listed expiry with a variable notional equal to the amount of capital. (With the S&P at 2,000, you would actually use $200,000 of capital and sell one CBOE contract with multiplier 100. S&P 500 ETF(SPY) options may provide an alternative for smaller notional or for fine-tuning.)